The retail price a household pays for the last unit of grid-supplied electricity consumed is an

N O V E M B E R 2 0 1 7 Retail Pricing to Support Cost-Effective Distributed Generation Investment by Frank A. Wolak, Director, Program on Energy and Sustainable Development; Professor, Department of Economics, Stanford University 1. Introduction The retail price a household pays for the last unit of grid-supplied electricity consumed is an important driver of the decision to install a rooftop solar photovoltaic (PV) system. This price is the cost a household avoids by consuming a kilowatt-hour (KWh) from their rooftop solar system. Consequently, if the levelized cost of a KWh from a rooftop solar system is less than this retail price, the household saves money by installing a rooftop solar system. 1 Historically, the retail price of electricity was set to approximate the vertically-integrated utility s average total cost of providing electricity to its retail consumers. This average cost is the ratio of the sum of total cost of the transmission and distribution and networks, the total cost of generating and purchasing the electricity sold to final consumers, the total cost of utility s retailing operations, and the total cost of utility-administered public policy programs designed to achieve social, energy efficiency, or environmental goals divided by the total amount of energy sold to consumers. In regions of the United States with formal wholesale electricity markets, such as the California Independent System Operator (ISO), the PJM Interconnection, the New England ISO and New York ISO, state public utilities commissions (PUCs) continue set retail electricity prices to recover this average cost. Average cost-based pricing for grid-supplied electricity can significantly improve the economic case for rooftop solar, particularly in California. For example, customers in the Pacific Gas and Electric service territory currently face an average retail price of 22 cents per KWh for their electricity. Because of increasing block pricing, where the marginal price paid for electricity increases with the customer s monthly consumption, customers on the highest marginal price tier pay 40 cents per KWh for their last unit of consumption. An investment in a rooftop solar system at $3.50 per Watt with a twenty-five year lifetime and assuming a 3 percent discount rate implies a levelized cost of energy of approximately 15 cents per KWh. Substituting 15 cent per KWh energy from a rooftop solar system for 40 cents per KWh electricity from the grid is a fantastic deal for the consumer. Even at the average retail price of 22 cents per KWh, investment in a rooftop solar system makes economic sense for the consumer. 1

However, this average retail price is also significantly above the annual average marginal cost of supplying the last KWh consumed to any consumer in California. According to the California ISO, the annual average hourly price of wholesale electricity in 2016 was 3.5 cents per KWh. The major variable cost caused by moving electricity from a generation unit to final consumers are the losses that occur between point of injection to the grid and point of withdrawal at the customer s premises. These losses average approximately 5 percent of electricity that produced each year in the United States. Consequently, annual average hourly marginal cost of grid supplied electricity in California during 2016 is very unlikely to be more than 4 cents per KWh. 2. INEFFICIENT BYPASS OF GRID-SUPPLIED ELECTRICITY These facts imply that at current average cost-based retail prices it is currently privately profitable for a customer to install a rooftop solar system, but it would be significantly less expensive on an industry-wide basis for the customer to purchase grid-supplied electricity at marginal cost throughout the year. Under the current retail pricing paradigm in California, the decision to install a rooftop solar system is an example of an activity that is privately profitable for the typical customer, but not the least cost solution for all of utility s customers. This outcome is caused by average cost pricing of transmission and distribution network services and the costs of utility administered public policy programs. Virtually all of these costs do not vary with the quantity of electricity delivered to the utility s customers, but by recovering these largely sunk fixed costs through a per unit charge, customers have a strong incentive to install a rooftop solar system which provides them with lower-priced electricity. 3. A LOOMING REGULATORY CRISIS What are the broader implications of average costbased pricing of retail electricity? As more distributed solar systems are installed, the quantity of grid-supplied electricity consumed falls. This logic implies that cents per KWh charge that recovers all of these sunk costs must increase because they must be recovered from sales of a smaller quantity of grid supplied electricity. According the California Energy Commission (CEC) there is almost 6,000 MW of residential and commercial solar energy systems in California. The annual increase in self-generation solar PV capacity has substantially increased each year from 2006 to 2016, as shown in Figure 1. This rapid increase in solar capacity implies FIGURE 1: Annual Additional Installed Self-Generation Capacity Source: www.energy.ca.gov/renewables/tracking_progress/documents/renewable.pdf 2

that the fixed costs of the transmission and distribution networks and utility-administered public programs must be recovered over a smaller amount of grid supplied electricity, which requires raising average retail prices. There is no guarantee that the distribution utility can continue to raise average retail prices indefinitely to recover these costs. There are a variety of reasons why a regulated utility that invests in the long-lived capital equipment (such as transmission and distribution networks) necessary to provide service to consumers may not recover these sunk costs. Hempling (2015) provides seven examples of a regulated entity that was denied cost recovery, several of which appear to applicable to case of distributed solar investments. 2 All of these reasons follow from the basic legal principle in regulatory ratemaking that a utility is only allowed the opportunity to recover its costs through prudent operation, not guaranteed recovery of these costs. Hempling (2015) goes on to emphasize that the courts have determined that utility investors enjoy no constitutional guarantee of stranded cost recovery. (p. 2). Consequently, one justification for the utility s shareholders bearing the brunt of the revenue shortfalls that result from distributed solar investments is that competition from distributed solar has led to partial obsolescence of the transmission and distribution grid, which has significantly reduced the revenues the utility is likely to earn from grid-supplied electricity. Therefore the utility s investors now own a less valuable asset and are not entitled to full recovery of these sunk costs. An argument for full cost recovery would be that because of the intermittent nature of distribution solar generation, the capacity of the existing transmission and distribution grid is necessary to serve both distributed solar and full requirements customers because it is sometimes the case the distributed solar systems are not producing any electricity and the transmission and distribution grid is utilized at the same capacity as would be the case in the absence of any distributed solar investments. The argument that transmission and distribution networks have the same annual peak utilization rates as they did without any distributed solar investments is increasingly difficult to make as the share of distributed solar capacity increases and the diversity of distributed solar locations increases. As more customers install distributed solar systems the political winds are likely to increasingly blow against full sunk cost recovery, which argues in favor of utilities and regulators getting in front of this issue as soon as possible. The solar installation trends documented in Figure 1 suggest an increasing urgency to address this issue in California. There is another reason to address this issue as soon as possible based on my own recent research. There considerable current debate over the impact of the rapid growth in distributed solar generation capacity and distribution network costs. Distribution network utility utilities argue that network upgrades are required to accommodate the significant amounts of distributed solar capacity in many parts of their networks. Solar installers argue that distributed solar capacity allows the utility to avoid many investments in network upgrades. Using data on quarterly average distribution prices for the three investor-owned utilities in California Pacific Gas and Electric, Southern California Edison, and San Diego Gas and Electric and quarterly data on cumulative solar PV capacity installed in each utility service territory from 2003 through the end of 2016 from the California Solar Initiative (CSI), I find that empirical evidence in favor of the hypothesis that distribution network charges have increased more than can be explained by the mechanical impact of less total withdrawals of grid supplied electricity. 3 Specifically, even after controlling for a slowdown in the growth of withdrawals of grid-supplied electricity in each utility s service territory, higher levels of cumulative 3

solar installs are associated with higher distribution charges for residential customers in that utility s service territory. In fact, I find that the almost doubling of the average residential distribution charge for each investor-owned utility from 2003 to 2016 can be almost entirely explained by increases in fixed cost of the distribution network, presumably due to investments to accommodate more distributed generation capacity. I also find evidence that these distribution charges increased more in during quarters and in utility service territories with more geographic concentration in the installed capacity of distributed solar PV systems. This result implies that the distribution utilities are currently in the uncomfortable position of making sunk investments in their networks to accommodate distributed solar PV systems that may eventually be rendered obsolete by future investments by customers in batteries and other load-shifting technologies. 4. TOWARD MORE EFFICIENT RETAIL PRICING So what can be done to address this looming regulatory crisis in sunk cost recovery? The first step is for the California Public Utilities Commissions (CPUC) to implement a retail pricing mechanism that reflects the reality that grid-supplied electricity now faces competition from distributed solar PV systems. Retail prices must be set so that the private cost versus benefit calculation for a household investing in distributed solar PV capacity is consistent with the societal cost versus benefit calculation for this investment. This is accomplished through marginal cost pricing of gridsupplied electricity to retail customers. Each of hour the default retail price faced by the household should equal to the marginal cost of supplying an additional KWh to that customer. This marginal cost is equal to the hourly wholesale price plus the marginal losses associated with delivering that KWh to the customer through the transmission network and distribution network. Returning to our earlier example, if the customer pays delivered marginal cost of electricity each hour of the year, the customer will should invest in distributed solar only if the annual average marginal cost of grid supplied electricity is greater than the levelized cost of a distributed solar installation. This decision rule is consistent with minimizing the societal costs associated with supplying that customer will electricity on an annual basis. This approach to retail pricing also ensures that the least cost choice between grid scale solar and rooftop will be made. Consider the case of customer that can purchase utility-scale solar energy or install distributed solar capacity on their premises. If the difference between the levelized cost of the rooftop solar system and the utility-scale solar system is larger than the annual average delivery cost, then a utility-scale solar system is the least cost source of solar energy. Delivering utility scale solar energy to the customer would require paying the hourly marginal cost of moving the energy from the point of injection of energy in the transmission network to point of withdrawal on the customer s premises and this cost is avoided by the customer installing a distributed solar system on their premises. Consequently, marginal pricing of the transmission and distribution networks would also align public and private incentives for utility-scale versus distributed solar PV investments. The only significant conceptual challenge with marginal cost pricing of the transmission and distribution networks is that this may not recover sufficient revenues to recover the sunk costs of these networks. The most straightforward way to recover this additional cost is through a customer-specific monthly fixed charge. Wolak (2017) develop a framework for determining how this monthly fixed charge would vary across customers according to their willingness to pay. The basic insight is that annual total of these monthly fixed charges for each customer should not be high enough to cause the customer to opt-out of having 4

access to grid-supplied electricity. At the other extreme, the annual total of all monthly fixed charges across customers should be sufficient to recover the utility s sunk costs. This approach to retail pricing implies a transition to a monthly cable bill approach to pricing access to the transmission and distribution network. Analogous to how cable customers pay a monthly fixed charge to watch much programming as they would like on any of the channels they subscribe to each month, the distribution utility s customers will pay a monthly fixed charge that allows them to consume as much grid-supplied electricity they would like at the hourly marginal cost providing this electricity. My analysis demonstrates that customers should pay different monthly fixed charges based on their annual willingness to have access to grid-supplied electricity. Customers with higher average hourly demands, more variable hourly demands, that face more variable hourly marginal costs of supplying them with retail electricity that are more highly correlated with their hourly demands should face higher monthly fixed charges because of their greater willingness to pay for grid-supplied electricity. 5. DEMAND CHARGES WHAT NOT TO DO A popular proposal among utilities for dealing with this sunk cost recovery problem is to impose demand charges. These require the customer to pay a dollar per KW charge based on their peak demand within a given time period, typically the monthly billing cycle. The utility would measure the customer s consumption during all hours or smaller time intervals within the month and charge them $/KW fee for the highest recorded value during that time period. Unless the customer s consumption is highly correlated with the peak demand on the distribution system, a demand charge does little to reduce the system peak demand or reduce the amount of future transmission and distribution network investments. Because every customer has a monthly peak demand, demand charges can be a very effective way to raise revenues, but it makes very little economic sense to assess a demand charge on a customer whose monthly peak demand occurs at 2 am on a weekend morning. Assessing a demand charge on a customer s consumption during the monthly peak for system demand or total demand within that customer s distribution network does provide an incentive to reduce demand during the highest demand period of the month and thereby reduce the need to upgrade the distribution network. However, this approach still requires administrative process to set the value of the demand charge, whereas setting the retail price equal to the hourly marginal cost of delivering energy to that customer does not. This approach to a demand charge fails to recognize that there are many other reasons why the transmission or distribution network operator would want a customer s demand to be reduced. For example, a transmission or generation unit outage could create a supply shortfall in a local area, which economic benefit from the customer reducing their demand. Hourly marginal cost pricing sends the efficient price signal during all hours of the year of the cost of delivering electricity to that customer. 6. CONCLUSION The transition from an electricity supply industry with dispatchable utility-scale generation units delivering grid-supplied electricity to consumers through the transmission and distribution network to an industry where consumers have the option to install distributed generation or grid-scale renewable generation resources has created the opportunity to adopters of distributed solar generation capacity to reduce the 5

amount they pay for the sunk costs of the transmission and distribution networks and utility-administered public policy programs. This paradigm shift in the electricity supply industry requires a change in how these costs are recovered from retail electricity prices. Marginal cost pricing of grid-supplied electricity with recovery of the remaining sunk costs through monthly fixed charges will align the least cost solution for investments in distributed solar capacity for individual customers with the least cost solution on a system-wide basis for investments in distributed solar capacity. It will also lead consumers to make the least cost choice between utility-scale solar and distributed solar in meeting renewable energy mandates. 6

ENDNOTES 1 The levelized cost of energy (LCOE) from a generation unit is defined as LCOE = where Ct is the net cost of the generation unit in year t=0,1,2,3,,t, Et is electricity produced in year t=1,2, T, r is the discount rate, and T is the number of years the generation unit is in service. If r=0 then the LCOE is simply the average cost of energy over the lifetime of the generation project. 2 Hempling, Scott (2015) From Streetcars to Solar Panels: Stranded Cost Policy in the United States, Energy Regulation Quarterly, Volume 3, Issue 3. 3 Wolak, Frank. A. (2017) The Economic Impact of Inefficient Distribution Network Pricing: Evidence from California and a Framework for a Proposed Solution, available at www.stanford.edu/~wolak. energy.stanford.edu/clean-energy-finance